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Dodd-Frank Reform: BASEL III and Capital Requirements

January 23, 2017

The House Financial Services Committee’s previous passage of the Creating Hope and Opportunity for Investors, Consumers, and Entrepreneurs” Act (“CHOICE Act”) provides a roadmap to potential financial regulatory reform early during the Trump administration, including reform of the Dodd-Frank Act’s and BASEL III’s bank capital requirements. House Committee on Financial Services Chairman Jeb Hensarling (R-TX-5) has indicated a desire to introduce a “2.0” version of the bill early in 2017 when the new Congress convenes.

Potential replacement of other regulations by a single leverage limit.

The CHOICE Act would create an “off-ramp” from capital and liquidity requirements under the Dodd-Frank and BASEL III for financial institutions that maintain a “high level of capital” (“qualified banking organizations”) --- a 10% ratio of “common equity Tier 1” (“CET 1”) to “total leverage exposure.”

Critics have argued that the 10% limit is weak because large banks already maintain close to 10% leverage ratios and such ratios are subject to manipulation.

The “off ramp” for all but “traditional banks,” however, is much more restrictive than the simple “leverage ratio” currently reported by U.S. banks that measures “tier 1 capital” against adjusted “average total consolidated assets.” For example, by instead measuring CET 1 capital against Basel III “total leverage exposure” (which adds off-balance sheet exposures), the 10% minimum would require the largest four U.S. bank holding companies to increase their existing CET 1 capital levels by roughly $370 billion (an increase of between 37.5% and 72.9% for each of the four). This, according to the four largest U.S. banks’ “Pillar 3 Regulatory Capital Disclosures” for the quarterly period ended September 30, 2016. On the other hand, the 10% CET 1 to total leverage exposure requirement seems to be less restrictive than the 23.5% CET 1 to risk-weighted assets and 15% CET 1 to balance sheet assets minimums recently proposed by the Federal Reserve Bank of Minneapolis for non-“systemically important” banking companies with assets of more than $250 billion.

Banks with no trading assets or liabilities and limited interest rate and foreign exchange swaps could qualify by using the traditional balance sheet leverage ratio (e., CET 1/adjusted average total consolidated assets).

The scope of the “off ramp” for QBO’s would also be controversial.

The CHOICE Act would exempt “qualifying banking organizations” (“QBO”s) from Basel III standards, such as the Liquidity Coverage Ratio (“LCR”), the Net Stable Funding Ratio (“NSFR”), and Globally-Systemic Important Banks (“G-SIB”) requirements, as it expressly exempts QBOs from all the Dodd-Frank Section 165 “enhanced standards” other than subsection (c) public disclosure and subsection (k) inclusion of off-balance sheet exposures in capital computations.

It would also clearly eliminate long standing risk-based capital requirements for QBOs as part of eliminating “any capital or liquidity” requirement other than the 10% leverage test.

The Choice Act provides that any QBO would be considered well-capitalized under “prompt corrective action” requirements. It would permit federal banking regulators to impose stress tests on QBOs (except the annual stress test required for companies with more than $10 billion but less than $50 billion in consolidated assets), but would eliminate the regulators’ ability to limit a QBOs “distributions,” which has been the enforcement tool for requiring better stress test results.

Critics have argued the “off-ramp” is only useful to the largest banks, because they are the only banks that would benefit from the exemption from enhanced prudential and other standards. However, this exemption from annual stress tests could be a motivation for smaller bank holding companies to select the “off-ramp.” They would also be freed from the obligation to compute risk-weighted assets under the risk‑based capital rules that apply to all banks. So long as such banks qualified as “traditional banks” they would only need to meet the standard balance sheet leverage test to qualify as a QBO.

The CHOICE Act would also expressly exempt a QBO from all “systemic risk” determinations in receiving regulatory approvals for acquisitions or other activities and from both the Dodd-Frank Section 622 concentration limits on large financial firms and the longstanding requirement that the deposit holdings of a bank holding company or insured depository institution may not exceed 10% of total deposit holdings of insured depository institutions in the U.S. after an acquisition. Section 622 of Dodd-Frank prohibits bank holding companies and insured depository institutions from making acquisitions if as a result the consolidated liabilities of the financial company would exceed 10% of the consolidated liabilities of all financial companies in the U.S.

Some commentators have suggested that the federal banking regulators could still impose all capital, liquidity, and other requirements on QBOs through normal supervisory evaluations under the CAMELS rating system or similar systems. The CHOICE Act, however, seems to require a CAMELS or equivalent “satisfactory” (e., 1 or 2) rating only for the most recent evaluation before a bank or bank holding company makes the QBO election. A QBO seems to lose that status only by failing the 10% test for four consecutive quarters or at any time the ratio reaches 6%.

The CHOICE Act requires that a bank holding company and all of its subsidiary banks jointly make a QBO election, so that no subsidiary bank or bank holding company could selectively gain such status.